Money Supply & The Credit Crunch

The other day my colleague came up with an interesting topic – where does money come from?

He got me thinking.  Thinking led to research and at the end of it, I realized how little I knew about the world of money and money supply.

So where exactly does money come from?

My tiny brain tried to come up with an intelligent answer – Central banks in the world must be printing money according to GDP’s of the respective countries. They must be hiring the best financial brains to calculate how much exactly must be printed. Once printed, money must be remaining in the system forever.

In the end, I was partially correct. Well rather, I was not entirely wrong.  The central bank being one of the players in the money supply part was correct. But everything else ….hmmm.

So here is the truth – Majority of the world’s supply of money is nothing but loans !!  Real money hardly exists. To be more precise, let’s say central banks print 100 units of a currency. That 100 real units of currency is loaned again and again by the commercial banks as long as a reserve is met.  This has a multiplier effect and apparently a real 100 units of currency can potentially grow up to 500 or even 1000 units of currency depending on the fractional reserve percentage.

And that my dear is the beauty of man’s creation – the fraction-reserve banking !!

Here’s a video that explains this concept in a very simple way -

A must read from the wiki -

http://en.wikipedia.org/wiki/Fractional-reserve_banking

Can you imagine what that means ?? If US central bank decides to flood the market with $500 billion, it should potentially create $2.5 trillion in the system !!

You must be wondering if the central banks have this magical power, what’s going on in this tumultuous period? Why is there a crunch in money supply at all?

The fact is that all the major central banks including the US Fed have pumped in trillions of dollars into the financial system. But the commercial banks are just not ready to lend them out. Remember the multiplier effect comes into play only if the banks lend.

So why are banks not lending? Banks are reeling under the effect of bad mortgages which were nothing but bad loans. The more they write down these loans, the more they are sucking out money from the system and lower their reserves go. So in order to maintain their balance sheets they have no other choice but to be conservative and save every penny possible.

So when does this end? My small brain has an answer – I don’t know !!  (And for now I think I am right)